It’s All About the Income
- Jun 20, 2018
The industry knows that the bull run for commercial real estate (CRE) appreciation and double-digit unleveraged returns are at the end of this cycle. We are currently in the second longest expansion in US history. According to recent research from Situs RERC, cap rates are primarily retreating from their historic lows; capital appreciation is continuing to go sideways in many cases and in certain cases will become negative in 2019. On the bright side, the tax cuts that were signed into law last year may buoy the US economy for a little while longer and we expect the downturn to be relatively modest rather than a major correction or crisis, with CRE prices declining, on average, by less than 5% over the next two years.
It is important to keep in mind that CRE is a long-term investment strategy that relies on capital appreciation for part of the total return. The total return for CRE is composed of income, accounting for a majority of the total return, plus some value or price appreciation. For those buying only for hefty annual appreciation, the effectiveness of that short-term strategy is coming to an end.
While the industry has some speculative investors, the attraction of the asset class is its favorable return vs. risk profile because of the ongoing, steady income stream and the fact this is a real asset. The income component of CRE is comparable to a bond with the appreciation being likened to a stock return, which is mostly price appreciation. This is particularly important for pension funds and insurance companies that rely on the income component of the return.
CRE income returns have been declining slightly over this past recovery period, but the stability of the income component, even during economic downturns, is considerable, especially compared to other traditional investment alternatives. While capital appreciation can fluctuate, the relatively safe and steady income component of CRE helps investors through economic rough patches and market volatility. Over the past 40 years, quarterly income return volatility as measured by the NCREIF Property Index (NPI) has been exceptionally low, as shown in the chart above. Even During the Great Financial Crisis (GFC), annual income returns dropped only slightly between 2007 and 2008.
Swings in the equity and bond markets continue to make investors nervous, but CRE persists as a stable asset class. The core benefits of investing in CRE include consistent cash flow, downside protection, tangibility and low correlation with other asset classes. As the cycle moves through its ninth year and interest rates finally start rising, CRE returns are expected to slowly retreat from their peaks. With capital appreciation eventually forecast to turn negative on average, and cash flow hitting a steady but slow level of growth, CRE will rely on income to drive total returns moving forward. But given the wildly fluctuating returns for other asset classes, investors seem content with the steady source of income.